12/04/2007 @ 6:00AM

Predatory Legislating

After months of deliberating over what, if anything, to do about the large number of defaults in the subprime industry and the lax lending and borrowing standards that led to them–the House has passed its answer: The Mortgage Reform and Anti-Predatory Lending Act of 2007. But while this bill purports to foster a well-functioning mortgage-market in which borrowers get affordable loans, it attempts to do so by making life impossible for lenders.

The bill tells lenders they may not engage in the undefined practice of “predatory lending”–examples of which include vague offenses such as offering loans that are not “solely in the best interest of the consumer” or offering loans that a borrower does not have a “reasonable ability to repay.”

Since the bill offers no clear standard of a “reasonable ability to repay” or the “best interest of the consumer,” if it is passed, lenders could be held liable for any loan a borrower fails to pay off. All an irresponsible borrower or unscrupulous lawyer needs to do is convince a jury in hindsight that the lender should have known better–and he can cash in at the lender’s expense. To compound the injustice, the new law would apply, not only to those who initiate loans that fail, but to any financial institution that buys and pools loans made by others (a practice that makes possible better risk management and lower mortgage rates).

If you were a mortgage lender facing this sword of Damocles for any loan that goes bad, what would you do? Exactly what mortgage lenders will do if this legislation passes: jack up rates to account for the high risk of lawsuits–and likely avoid lending to higher-risk candidates altogether. Is this going to protect the lower-income home-buyers that “predatory lending” opponents claim to treasure? Is this going to yield a well-functioning mortgage market?

This bill is so bad that even many of the congressmen who voted for it acknowledge that it has problems. But, in the words of Rep. Spencer Bachus, R-Ala., they believe “we need not let the perfect get in the way of the good”–”the good” here being some kind of government crackdown on mortgage lenders to prevent the lending and borrowing practices that have caused lenders to lose billions and borrowers to lose their homes.

But no government crackdown is needed to promote borrowing and lending that allows lenders to make a profit and borrowers to keep their homes. If the market is left free to function, participants learn from their mistakes and adjust. By the nature of the mortgage market, it is both in lenders’ long-term interest and borrowers’ long-term interest for loans to be paid off. That’s how lenders profit and borrowers keep their homes.

When bad loans are made, both borrowers and lenders are punished–and must correct course. Observe that Wall Street financial firms and direct lenders who engaged in lax lending are suffering huge losses (such as Merrill Lynch‘s
$8 billion loss) and internal upheaval–and have changed their practices accordingly. The number of subprime, adjustable-rate mortgages has declined by 50% this year. As for the middlemen who tried to make (and often succeeded in doing so) a quick buck on dubious loans, their reputations are sullied and their business has dried up.

The government does not need to crack down on lenders. It does need to take responsibility for itsrole in promoting irresponsible lending and borrowing practices through its myriad interventionist programs to “promote homeownership.” The very concept of the government having such a goal means that it facilitates borrowing and lending that would not occur on the free market–i.e., a market in which people are held fully responsible for their decisions.

One example of this is the Community Reinvestment Act, which literally forces banks to lend to people with high credit risk. Another is the Federal Reserve’s policy of creating artificially low interest rates, which encouraged financial institutions to lend out more money for mortgages than they otherwise would have–and which helped artificially bid up housing prices and fed the fervor that buying a home at any price is a can’t-miss investment that all Americans should make. The government’s promotion of home-buying was a recipe for irresponsibility–and that’s exactly what it produced.

If commentators and politicians took a fair look at the problems of the mortgage industry, they would acknowledge the self-correcting actions of those in the market who are taking responsibility for their mistakes by changing their behavior while calling for the abolition of the government’s destructive “pro-homeownership” interventions. But this has not happened. There has been no widespread questioning of government “pro-homeownership” policies, let alone opposition to them. Yet there is a rush to pass a truly punishing piece of legislation that will benefit no one besides the unscrupulous borrowers and lawyers who will use it to shake down the lending industry.

Why is the knee-jerk response to the subprime defaults to blame business first? Because of the common belief that the cause of any and all economic problems is unrestrained profit-seeking by businessmen. Most Americans believe, on some level, that the profit motive is morally tainted, if not outright immoral; thus, the safest political response to subprime problems is to intimidate all businessmen in the mortgage industry with vague prohibitions and big punishments.

This is exactly the attitude that got us Sarbanes-Oxley in 2002. While that law is now recognized by many to be economically disastrous, it was rushed through Congress and passed 97-0 in the Senate. We must not let Congress commit the same sin in the housing market.

Yaron Brook is managing director of BH Equity Research and executive director of the Ayn Rand Institute.